Your Financial Evolution: Asset Allocation

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Asset Allocation pertains to how you want to divide the total pie (your overall portfolio) with respect to the various asset classes you want to be invested in (i.e. how each class is weighted).

There is no one golden Asset Allocation that is guaranteed to provide the best results. Again it comes down to individual factors that determine whether one asset allocation is more appropriate than the other.

Factors such as an individual’s risk tolerance and age can dramatically change how various assets should be weighted.

Stock Allocation:

One of the first major decisions to be made is how much exposure do you want to have to equities (stocks).

As mentioned in our Stock Primer, stocks have great growth potential but also come with great volatility (something that may not be tolerable when you are relying on fixed income sources in retirement).

A very general rule of thumb is (120- your age) = % of stocks you should allocated in your portfolio (some people have used (100-age) but others have found this too conservative)

For example: If you are 40 years old, 120-40= 80% stock weighting.

It also general consensus to also geographically diversify your stock allocation geographically:

Domestic (US)

International (most recommend 10-30% international)

So for the above 40 year old who has 80% of his portfolio in stocks, 70% of that can be domestic (56% of total portfolio value (0.8 x 0.7)), 30% of that can be international (24% of total portfolio value (.8 x .3))

Bond Allocation:

As mentioned in our Bond Primer, bonds have typically lower growth potential than equities, but less volatility (considered fixed income type asset class)

Preferential place for tax efficient assets (equities with qualified dividends, index funds) that have distributions taxed at a much more favorable capital gains tax rate.

Rebalancing:

As each individual asset class behaves differently in a particular market cycle (which is actually a desired benefit of diversification), the subsequent weighting of that class to the overall portfolio will diverge from your initial assignments.

It is therefore important to continue to monitor your portfolio and periodically rebalance it to bring the assets back in line.

Rationale for Rebalancing:

Allows one to sell high and buy low (by rebalancing you sell asset classes that have outperformed the others and buy asset classes that have declined).

This goes against typical investor behavior where there is a tendency to want to hold on to or buy more of one’s “winners” and get rid of one’s “losers” (buy high, sell low)

Recency bias has major influence on this behavior and can lead to investors chasing the market leading to potential bubble type sell offs.

Asset classes tend to cycle in and out of favor and every dog will eventually have it’s day in the sun.

Today’s losers will eventually become tomorrow’s winners. Better to buy them at a discount now.

Different Ways to Rebalance:

Time horizon based:

After a predetermined period of time (such as annually), a detailed portfolio analysis can be performed to determine the current weighting of assets. At that point rebalancing of the asset classes to go back to the original percentage assigned

Pros: Much less hands on/less time consuming

Cons: Depending on how the market behaves, assets may be substantially out of desired percent allocation for significant time before any action taken

Allocation tolerance band based:

Sets a tolerance band or percent range that an asset can be in before triggering a rebalancing event (I personally use 10% of the initial percent assigned to find my tolerance range)

For instance, using our 40 yr old individual example above with a 3 fund allocation:

US/domestic stock. Desired 56% overall portfolio. Can have a tolerance band of +/- 5%

This asset can go as low as 51% or as high as 61% before needing to be rebalanced.

International stock: Desired 24% overall portfolio. Can have a tolerance band of +/- 2.5%

Bonds: Desired 20% overall portfolio. Can have a tolerance band of +/- 2%.

Pros: Tighter reign on the assets preventing large deviations from occurring

Cons: Can be more labor intensive with more frequent monitoring of how each asset class is performing

Methods of Rebalancing

Can sell or buy holdings to bring asset classes back in line

Caveat:

Be wary of potential transactions costs/redemption fees etc that can erode the benefits of rebalancing

Be wary of potential taxable events that occur (if sell a holding for a gain in a taxable account, will be subject to either short term or long term capital gains (if possible sell holdings in a retirement/tax-deferred account to avoid this)

Selling one’s “losers” is best accomplished in taxable accounts if possible as you can claim those losses on your tax return to get deduction.

Can channel new money into under-performing assets to bring back into target allocation range.

This is the method I prefer and currently use

Key Point:

Remember that whatever asset allocation you decide to construct your portfolio, you should treat all your financial holdings as one whole entity.

You therefore must calculate the combined total of your assets from retirement accounts and taxable accounts rather than treat them separately if you truly want to have your portfolio balanced the way you want.

Superhero Take-home Points:

A properly constructed (age appropriate/risk tolerance appropriate) Asset Allocation can provide diversification to increase likelihood of continued financial success throughout all market conditions

The goal of every investor to “buy low and sell high” can be implemented by periodic rebalancing

Be cognizant of how selling assets can give you the best tax break either by avoiding capital gains when done in a tax deferred account or capturing tax deductions using losses in a taxable account.

Do not treat retirement and taxable accounts as separate entities for asset allocation purposes.

What method of rebalancing do you employ for your portfolio? Comment below.

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Appreciate the comment and I agree if you do have an asset allocation that is appropriate for your age and risk tolerance you can weather market downturns and not have a knee-jerk reaction to sell and lock in the losses. Thanks for stopping by.

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1 year ago

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The Physician Philosopher

Good overview, Xrayvsn! As someone close to me once said, “You can never hear true things enough!”

Thanks TPP. I wanted to have the basics available on my site for convenience to people who may need it. Nothing earth shattering since information already out there but wanted to put my spin on it. Thanks for stopping by

Agree. A majority of my retirement funds are in what I call the “scary” funds, haha. My dad’s conditioned me from a young age to ride out the volatile market while I’m young, because it’s always curving up over the long haul. If you’re confident in your asset allocation, you won’t be terrified when it plummets — and who knows, that may be coming soon, right? I’ll just close my eyes.

Thanks MFM for stopping by. Seems like you have adopted a higher risk profile from early days and as long as you can stomach any drops in the market you will not lock in the losses by panic selling. Unfortunately most investors seem to not be able to do this and having a more balanced portfolio may soften the blow and prevent the knee jerk response that occurs when assets start rapidly declining. With one of the longest bull runs we have had in history a lot of younger investors don’t know what it is like to see drops of… Read more »

Thanks DMB. 🙂 I try to stick pretty close to my Investment Policy Statement and Asset Allocation philosophy and stay the course. It has served me well so far (didn’t go chasing Bitcoins when it was all the rage for example). In the end I think being balanced and steady will result in plenty enough for me. I don’t need to go chasing the latest fad in hopes of getting high reward at the cost of high risk.

Great overview! And I like how you mention your preferred method of rebalancing by buying more under performing assets to bring back to target allocation. Do you prefer this method due to simplicity? Do you tax loss harvest? Does it ever make sense to sell “winners” in a taxable account when you’re in the accumulation phase? I’m just curious and trying to learn a bit more. Thanks for your insight!

Hey DMF. I appreciate the visit and comment. I prefer directing new money as my method of rebalancing because it is seems to be a bit easier to do and it avoids potential costs/tax hits if done in the wrong accounts. In the end it achieves the same results without the hassle of selling anything (of course if something is completely out of balance, new money might not be enough to make it so and I have employed the other method of selling “winners” buying “losers.” As far as tax loss harvesting, I have actually used it to my advantage… Read more »

Thanks for the detailed response. It was very helpful. I haven’t had a chance to tax loss harvest during this bull market. If I did tax loss harvest though, doesn’t it reduce the overall cost basis, which in turn will require me to pay more taxes later? If this is the case, is it worth the hassle to tax loss harvest? I could potentially see the benefit of tax rate arbitrage (deferring the taxes later when you would potentially be in a lower tax bracket in retirement), but I’m just not sure how much of a a benefit it really… Read more »

You are correct that tax loss harvesting lowers your basis in whatever asset you are harvesting (which means you have a larger gain if you ever sell). The rationale why this may still be beneficial is: 1) Potential lower tax rate when you sell than you currently are in (can make senses if in the top tax bracket as a physician now and don’t expect to be in retirement. Problem is you don’t know if tax rates will increase or not or whether or not you will be in a high tax bracket regardless if your retirement portfolio and RMD… Read more »